There are times that an exchanger may want to build their replacement property or might have specific criteria on what they want in the new property. For instance, the exchanger may be selling their current office building or want to build a new office building. An improvement or construction 1031 exchange is a perfect strategy for this type of situation.
By doing a construction exchange, you can use exchange dollars to make an improvement to the replacement property. This means that you can add improvement to your new property before you take title to it. So, you will have to set up what is called an Exchange Accommodation Titleholder that will step in your shoes and buy the replacement property using the exchange proceeds
In a construction exchange, the challenge is two-fold—the value of the property that you need and the 180-day timing period. When you sell your relinquished property, you’ll need to buy a replacement property or make improvements that cost the same price or more than what you sold.
What is a Typical Description of an Improvement Exchange?
Let’s assume you sold your relinquished property for a million dollars, the proceeds from the sale go to your designated qualified intermediary. Now that you have identified your replacement property for $600k, you will have to park the replacement property with your QI using a parking arrangement.
Usually, your QI will hold it under a special purpose LLC, which is typically referred to as an Exchanging Accommodating Titleholder. You can within the allotted 180-day window work a draw request arrangement with your QI to have additional exchange dollars go towards capital improvement for the property. Remember that the improvements need to be real property improvements, and they need to be completed within 180 days.
Also, these improvements need to be in service and completed by the end of the 180th day to make it qualify. So, for our example above, instead of buying the new property for $600k, your QI steps in, form an LLC, buys the replacement property, and make the improvements till it is completed. The goal is to use the remaining exchange dollars ($400k) to make capital improvements to meet up the million-dollar threshold, which you sold your relinquished property.
What are the Steps to Completing a Construction/Improvement 1031 Exchange?
- Since you are unable to exchange into a property that you already own. You, the exchanger, can’t acquire the replacement property and must have your qualified intermediary pay for the improvements with the exchange funds.
- Your qualified intermediary will need to set up a new LLC that is known as Exchange Accommodation Titleholder to hold title once the replacement property is acquired.
- Then the Qualified Intermediary uses the exchange proceeds to pay for the improvements, and whenever it is completed or on the 180th day, the exchanger accommodation titleholder transfers the LLC to you.
Remember that there may be additional steps or processes to undergo before the completion of the exchange. Check with your CPA for more detailed information.
Can an Improvement Exchange Exceed the 180 days Timing Period?
The short answer is sometimes Yes. However, if such a circumstance occurs, you can extend the exchange by using a reverse construction exchange.
What Are The Types Of An Improvement 1031 Exchange?
There are two (2) basic types of improvement 1031 exchange. They include;
- Delayed Improvement Exchange
In a delayed improvement exchange, you will have to relinquish your old property first, and the sale proceeds go to your QI. After the sale, you must identify a potential replacement property and submit the necessary construction plans within the 45 days identification window period.
After that, the EAT purchases the replacement property on your behalf and handles the construction from the remaining exchange dollars. Note that under this type of improvement exchange, you may take title to the property once the 180 days is complete or the value of the replacement property and construction cost equals the value of the relinquished property you sold.
- Reverse Improvement Exchange
Like the traditional reverse exchange, your QI will have to acquire the replacement property first before selling your relinquished property. While this type of arrangement may afford you flexibility, you may need to get a loan from a hard lender to finance the purchase. The EAT handles the construction cost, but you will have to fund these costs from your own pocket or by using loans.
Also, your QI will need to sell your relinquished property within 180 days. You may have to take title to the replacement property when the 180 days elapse or when the value of the new property and construction cost equals or exceeds the value of the relinquished property.
What are the Pros & Cons of Doing an Improvement 1031 Exchange?
- It allows you to use exchange dollars for replacement property improvements instead of using a loan.
- The 180 days’ timeline may be extended if the value of the relinquished property sold is equalized before the end of the deadline.
- It allows you to purchase a replacement property of any value since you will have the opportunity to use the leftover exchange dollars for improvement purposes.
- The timeline is not enough to embark on any serious construction or improvement project.
- The improvement exchange is far more expensive than other types of exchanges since the exchange accommodating titleholder receives the title. This could lead to extra charges or costs on transfers, escrows, and closing costs since the EAT is expected to transfer the property deed to you.
- A construction 1031 exchange can be challenging to carry out due to its complex processes. Infact, it involves more risk. This is the primary reason why you should hire an experienced exchange company to mitigate the risks.